Last year saw a boom in the market for SPACs, or special purpose acquisition companies. Almost 250 SPACs raised more than $80 billion in initial public offerings (IPOs) during 2020. This trend did not let up as the calendar year turned. SPACs raised more capital in January and February of 2021 than in all of 2020. However, beginning in April, we saw a drastic decline in the number of SPACs. While approximately 320 SPAC IPOs took place in the first quarter of 2021, the numbers in April declined by 90 percent. The downward trend has largely continued since.
One possible cause of the SPAC slowdown is the spate of pronouncements by the U.S. Securities and Exchange Commission (SEC), which seems concerned about the adequacy of disclosures to investors and potential conflicts of interests by management and sponsors. SPACs are typically viewed as a more seamless method of conducting an IPO compared to traditional IPOs and, given the enormous popularity of these transactions over the last several years, the SEC is signaling that more restrictions are needed in order to ensure investor protection.
In an appearance before the House Appropriations Subcommittee on Financial Services and General Government in May, SEC Chair Gary Gensler said he is concerned about whether SPAC investors are adequately protected by the SEC and if retail investors are receiving accurate information about SPAC transactions. Additional rules and recommendations are under consideration to protect SPAC investors, he said. In June, the SEC announced that its regulatory agenda includes proposing SPAC rule amendments in April 2022.
SPACs Are a Unique Investment Vehicle
A SPAC, also known as a blank check IPO or a shell company, is a company with no operations or assets. A SPAC is formed with the sole purpose of raising capital through an IPO to acquire a private operating company. These shell companies are set up by a management team, which often consists of investors or sponsors with expertise in a specific industry. The management team typically holds sponsor shares in the SPAC, while the remaining interest is held by public shareholders. Since the SPAC will become a publicly traded company, it is required to comply with the SEC’s regulations. The securities issued by SPACs are typically a unit containing a share of stock and a fraction of a stock warrant. Investors are unaware of what private company the SPAC will seek to merge with since the identification of a target company takes place after the IPO stage. The SPAC typically has between 18 and 24 months to acquire a target company, commonly referred to as the de-SPAC transaction.
If the SPAC does not complete a merger within the specified period set forth in its registration statement, it must liquidate and return the shareholders’ pro rata share of the aggregate amount still on deposit in the trust account. If the SPAC acquires a target company within its stated timeframe, the de-SPAC transition can take place. Once the merger is completed, the target company becomes a public company and must comply with SEC disclosure and regulatory requirements.
Disclosure Is Going to Tighten
The first indication of a crackdown on SPACs came in December when the SEC's Division of Corporation Finance issued guidance on disclosure of conflicts of interests for SPACs. A SPAC IPO must disclose if its sponsors, officers, directors, or management team have interests in other companies that could conflict with their obligations to the SPAC. This includes organizations that might compete with the SPAC for merger opportunities or that have competing financial interests. Insiders also must disclose any conflicts related to their SPAC compensation or financial incentives to complete the merger within a specified time.
There is long list of disclosure recommendations, including the percentage of the vote for the merger controlled by the insiders, whether the time to find a target and other actions can be taken without shareholder consent, details on the prior experience of the sponsors and other insiders, compensation agreements between the SPAC and underwriter, whether additional funding may be needed, and the terms of any forward purchase agreements.
The SEC also wants to see additional disclosure of de-SPAC transactions, including terms of additional financing, terms for conversion of convertible securities, details of the selection process for a target company, SPAC insiders' conflicts of interests with the target company, whether additional services are being provided to the SPAC by the underwriter of the IPO, and a fairness opinion assessing if the merger is in the best interests of shareholders. (See the SEC's December statement here.)
Better Recordkeeping Will Be Required
In March, the SEC published a staff statement reminding SPACs they must comply with existing requirements to "maintain books, records and accounts in reasonable detail that accurately and fairly reflect the issuer's transactions and dispositions of its assets ... [and] advise and maintain a system of internal accounting controls." When a SPAC merges with a target company, the SEC statement said, the new public company must be capable of meeting its public reporting requirements. (See the SEC's statement here.)
SEC Warns of Potential Legal Liability
Then in April, the SEC tightened up its requirements even more, issuing a statement that cautioned against believing the SPAC process allows forward-looking statements that could not be made in a conventional IPO.
There has been a perception that de-SPACs benefit from not being subject to the same liability exposure on forward-looking statements that attach to traditional IPOs, due to a safe harbor provision in the Private Securities Litigation Reform Act. The SEC warned that such a safe harbor does not apply to SEC enforcement actions and applies to private litigation only if certain conditions are met, including "meaningful cautionary statements" and a forward-looking statement that does not contain omissions or misrepresentations. Probably the most important part of the statement is the uncertainty it created. As it stands, the safe harbor applies only to de-SPACS – not IPOs, and the SEC warned that it could change the definition of an IPO to include de-SPACs. (See the SEC's statement here.)
Warrants May Be Liabilities, Not Equity
Just days later, the SEC said that warrants issued by SPACs may be required to be accounted for as a liability rather than equity under generally accepted accounting principles (GAAP) if there is a provision to change the settlement amount of the warrant, or if the holder of the warrant is entitled to receive cash in a tender offer and holders of common stock do not have the same right. This could require a restatement of prior financial statements for many companies. (See the SEC's statement here.)
SPACs Remain Viable
None of this means investors or sponsors should necessarily shy away from SPACs, which remain a creative way to invest in undervalued companies. Many SPACs have a track record of launching profitable public companies, and tighter disclosure and other rules won't derail that success. Sponsors and organizers should assume, however, that SPACs will be held to the higher disclosure, liability, and accounting rules that are under discussion, and they must be more buttoned-down and attentive to conflicts and regulatory details in the initial stages of capital raises than they were in the past.